Churches face a number of unique tax compliance considerations, filing requirements (and exceptions) that don't apply to other tax-exempt not-for-profits. This creates a good deal of confusion. In response to members' questions, the AICPA Not-for-Profit Section has compiled this list of frequently asked questions regarding church schools.
For the purposes of this article, we are using the word "church" in the general sense and are including houses of worship such as synagogues, mosques and other such faith-based recognized by the IRS as tax-exempt.
1. Can teachers in our school who are ministers receive a housing allowance?
If the school is not separately incorporated, or if it is an integral agency of the church, then ministers teaching in the school will be eligible to be treated as ministers on the same basis as if they were working in the other church ministries.
“Integral agency” is a separately incorporated entity, which has a sufficiently close relationship to a church, to be treated as a church for minister taxation purposes. The IRS provided criteria to determine if a separately incorporated school is an integral agency of a church (See Rev. Rul. 72-606; 70-549) listed below:
- The church incorporated the school;
- The school’s name indicates a church relationship;
- The church continuously controls the school;
- The school’s directors must be approved by the church;
- The school’s directors may be removed by the church;
- Annual reports of finances and operations of the school must be made to the church;
- The church financially supports the school; and
- If the school dissolves, its assets would go to the church.
The IRS has said that absence of one or more of these attributes will not automatically disqualify an organization. In addition, the IRS may ask the church about the relationship to the school. If the school is separately incorporated and is not an integral agency, then ministers working in the school are only eligible for a housing allowance and other minister treatment if:
- The minister is assigned by his or her church to work at the school at the time the minister was hired, or
- A substantial amount of the minister’s time involves leading worship or performing sacerdotal duties for the school. A minister serving as a chaplain for the school, and teaching courses on a religious text would typically qualify.
Additional information about assignments and ministerial services is available in IRS Publication 517- Social Security and Other Information for Members of the Clergy & Religious Workers at: http://www.irs.gov/pub/irs-pdf/p517.pdf.
2. Will our church school have to file an annual IRS Form 990 Return of Organization Exempt From Income Tax if it is a separate corporation?
One of the exemptions from filing IRS Form 990 applies to a school below the college level that is affiliated with a church. The easiest way to show affiliation would be the requirement that at least a majority of the school’s directors be appointed by the church, although other facts and circumstances can be used.
A separately incorporated school usually must file IRS Form 1023- Application for Tax Exemption. To be exempt from filing IRS Form 990, the exemption application must claim in the appropriate place that it is exemption and show as part of the exemption application why it is exempt from the annual filing requirement.
Note that a church school may want to investigate the filing of IRS Form 8940 - Request for Miscellaneous Determination if they do not believe they are required to file IRS Form 990. The instructions to IRS Form 8940, Part II, Line 8d set forth the conditions that a school might be considered a church, integrated auxiliary of a church, or a church affiliate. The IRS Form 8940 instructions can be found at: http://www.irs.gov/pub/irs-pdf/i8940.pdf
3. Does our school have to prove it doesn’t discriminate based on race?
All schools, whether they are church related or not, and even if they are not separately incorporated, should annually file with the IRS to confirm the school meets racial non-discrimination requirements. Schools filing IRS Form 990 provide this certification on Schedule E of the return. Schools that do not file IRS Form 990 file IRS Form 5578 - Annual Certification of Racial Nondiscrimination for a Private School Exempt from Income Tax.
4. What are the consequences of failure to file IRS 5578?
There is no explicit penalty for failure to file IRS Form 5578. A church related school that discovers the requirement and has not been filing IRS Form 5578 should begin filing. Failure to annually certify compliance and failure to comply with the requirements may be treated as evidence of racial discrimination. Religious schools have lost their tax exemption because of racial discrimination.
5. How does a school certify that they meet the racial non-discrimination provisions of the law?
By filing either Schedule E with your IRS Form 990 or IRS Form 5578 in a timely manner.
Every year, every tax exempt school must certify to the IRS that it does not discriminate on the basis of race. The Supreme Court ruled in 1983 that a racially discriminatory school could not be tax exempt and that religion was not a defense. Schools certify non-discrimination on Schedule E if they file Form 990 or on Form 5578 if they do not file Form 990 (because they are associated with a church). The following summarizes critical requirements (details are found in the instructions to either form, available at www.irs.gov):
- Board approval of a racial non-discrimination policy must be documented.
- All brochures and websites used for recruiting students must include a non-discrimination statement. The IRS approved wording is provided below:
- The [name of school] admits students of any race, color, national and ethnic origin to all the rights, privileges, programs, and activities generally accorded or made available to students at the school. It does not discriminate on the basis of race, color, national and ethnic origin in administration of its educational policies, admissions policies, scholarship and loan programs, and athletic and other school-administered programs.
- The school must annually publicize its nondiscrimination policy in a newspaper or broadcast media. The method used must be reasonably expected to reach all segments of the community served. Approved alternatives are available for church related schools where 75% or more of students are from the church, schools which draw a substantial percentage of students nationally or worldwide, and schools which the IRS determines have a substantial minority enrollment. Carefully study the publicity requirements, found in the form instructions, to ensure compliance.
- In addition, records should be kept to:
- Document the racial composition of the student body, faculty and administrative staff (estimates are allowed).
- Document that scholarships and other financial assistance are awarded on a nondiscriminatory basis.
- Maintain record of written communications regarding students and solicitations of contributions.
IRS Revenue Procedure 71-447 has these statements about non-compliance and record keeping:
Failure to comply. Failure to comply with the guidelines will ordinarily result in the proposed revocation of the exempt status of a school. ...
Failure to maintain records. Failure to maintain or to produce upon the proper request the required records and information will create a presumption that the organization has failed to comply with these guidelines.
6. Is there a penalty or correction process for schools that discover they are not in compliance or lack necessary records?
There is no formal correction process (or penalty). The school should immediately begin complying and keeping records. A history of compliance after discovery of the requirements will carry substantial weight if any issues are raised in an IRS audit about racial nondiscrimination.
This tax requirement only applies to racial discrimination. These rules are more fully explained in the instructions to Schedule E of Form 990 and can be found at: https://www.irs.gov/pub/irs-pdf/f990se.pdf
7. Are employees of the church eligible for a tax-free tuition discount?
Employees of a school can have a tax-free tuition discount (IRC 117(d)). The school can determine who is eligible, and the amount of the tuition discount. There must be a plan that does not discriminate in favor of highly compensated employees. The tax rules for employees are:
- Employees of the church who work in the school, whether or not it is a separate corporation, can be eligible for the tax benefit, provided the school’s plan covers them.
- Employees of the church that do not work in the school (even if they work in the same corporation as the school) are not eligible for the tax-free tuition discount.
The tax rules can be complicated in some church-school operations. Careful attention to job responsibilities and allocation may be needed to assess whether a person paid by the church, works in the school.
IRS Form 990 Schedule E - Schools
IRS Form 5578 Annual Certification of Racial Nondiscrimination
IRS Form 8940 For Miscellaneous Determination Requests